A LOT of payrolls get paid at the end of the month. The next for many companies is September 30. Three different people with hugely relevant knowledge said to me today words to the effect of: "Why don't your economist buddies want [insert fortune 100 company/companies here] to be able to pay their employees on Tuesday. If Washington doesn't do something now, they won't be able to". That just scared the hell out of me. I can go into more details if you like, but all of them involve the four horsemen of the apocalypse.

Greg Mankiw responds to this friend that he too has reservation about the details of the plan. However, given the urgency of the situation, he believes we should ultimately follow Bernanke's lead:

I know Ben Bernanke well. Ben is at least as smart as any of the economists who signed that letter or are complaining on blogs or editorial pages about the proposed policy. Moreover, Ben is far better informed than the critics. The Fed staff includes some of the best policy economists around. In his capacity as Fed chair, Ben understands the situation, as well as the pros, cons, and feasibility of the alternative policy options, better than any professor sitting alone in his office possibly could.

If I were a member of Congress, I would sit down with Ben, privately, to get his candid view. If he thinks this is the right thing to do, I would put my qualms aside and follow his advice.

Greg is correct here in terms of acting soon. However, I am on board with Paul Krugman and other economists who see the original Paulson plan failing to address the capital shortage problem. In case you missed this part of the debate, Sebastian Mallaby sums it up nicely:

How can the Treasury encourage private players to back up its purchases? The short answer is: Buy cheaply. If the government pays, say, 30 percent of what the loans were originally worth, any hedge fund that thinks they are really worth 40 percent will dive into the market. If the government pays 50 percent of what the loans were originally worth, that same hedge fund will stay on the sidelines -- or may even figure out a way of betting against the government.

[...]

[However,]Paulson and Bernanke... shrink from buying loans cheaply because doing so would force banks that currently value loans at high prices to recognize big losses, leaving them with too little capital. Buying loans cheaply would solve the liquidity problem in the loan market, but it would also reveal banks' capital shortage.

The way around this problem is for the Treasury to buy equity in the distressed institutions directly. Lucian Bebchuk explains it like this:

[Treasury buying troubled assets at fair market value--buying cheaply--] may leave us with concerns about the stability of some financial firms. Because falling housing prices depressed the value of troubled assets, some financial firms might still be seriously undercapitalized even after selling these assets at today's fair market value. That is, of course, why the Treasury wants the power to overpay. It wants to be able to improve the capital position of firms with troubled assets, restore stability and prevent creditor runs.

But the best way to infuse additional capital where needed is not by giving gifts to the firms' shareholders and bondholders. Rather, the provision of such additional capital should be done directly, aboveboard. While the draft legislation permits only the purchase of pre-existing assets, the final legislation should permit the Treasury to purchase new securities issued by financial firms needing additional capital. With the Treasury required to purchase securities at fair market value, taxpayers will not lose money also on these purchases.

Furthermore, this direct approach would do a better job in providing capital where it is most useful. Why? Because simply buying existing distressed assets won't necessarily channel the capital where it needs to go. Allowing the infusion of capital directly for consideration in new securities can do so.

Note that this approach makes existing shareholders "bail in" some of the losses--since their existing equity shares will be diluted in value--as opposed to having taxpayers completely bail them out. I find this approach to be a more equitable one for the taxpayers.

Thursday, September 25, 2008

1. The Fed spikes the punch bowl. In the wake of the dot-com bust and 9/11, the Fed lowers interest rates to 1 percent, the lowest since 1958. For more than 2½ years, long after the economy has resumed growing, the Fed funds rate remains lower than the rate of inflation. For banks, in effect, money is free.

2. Leverage soars. Financial sector debt, household debt, and home prices all double. Big banks shift their business models away from executing transactions for customers to “principal trading”—or gambling from their own accounts with borrowed money. In 2007, the principal-trading accounts at Citigroup, JPMorgan Chase, Goldman Sachs, and Merrill Lynch balloon to $1.3 trillion.

3. Consumers throw a toga party. Soaring home prices convert houses into ATMs. In the 2000s, consumers extract more than $4 trillion from their homes in net free cash (excluding financing costs and housing investment). From 2004 through 2006, such extractions exceed 7 percent of disposable personal income. Personal consumption surges from its traditional 66 to 67 percent of GDP to 72 percent by 2007, the highest rate on record.

4. A dollar tsunami. The United States’ current-account deficits exceed $4.9 trillion from 2000 through 2007, almost all for oil or consumer goods. (The current account is the most complete measure of U.S. trade, as it encompasses goods, services, and capital and financial flows.) Economists, including one Ben S. Bernanke, argue that a “global savings glut” will force the world to absorb dollars for another 10 or 20 years. They’re wrong.

5. Yields plummet. The cash flood sweeps across all risky assets. With so many people taking advantage of cheap loans, the most risky mortgage-backed securities carry only slightly higher interest rates than ultra-safe government bonds. The leverage, or level of borrowing, on private-equity company buyout deals jumps by 50 percent. Takeover funds load even more debt onto their portfolio companies to finance big cash dividends for themselves.

6. Hedge funds peddle crystal meth. Aggressive investors pour money into hedge funds generating artificially high returns by betting with borrowed money. To maximize yields, hedge funds also gravitate to the riskiest mortgages, like subprime, and to the riskiest bonds, which absorb losses on complex pools of lower-quality mortgages known as collateralized debt obligations or CDOs. The profits from selling bonds based on very risky underlying securities override bankers’ traditional risk aversion. By 2006, high-risk lending becomes the norm in the home-mortgage industry.

7. A ratings antigravity machine. Pension funds cannot generally invest in very risky paper as a mainstream asset class. So, banks and investment banks, with the acquiescence of the ratings agencies, create “structured” bonds with an illusion of safety. Eighty million dollars of “senior” CDO bonds backed by a $100 million pool of subprime mortgages will not incur losses until the defaults in the pool exceed 20 percent. The ratings agencies confer triple-A ratings on such bonds; investors assume they are equivalent to default-proof U.S. Treasury bonds or blue-chip corporates. To their shock, investors around the world discover that as pool defaults start rising, their senior CDO bonds rapidly lose trading value long before they suffer actual defaults.

8. The Wile E. Coyote moment arrives. Suddenly last summer, all the pretenses start to come undone, and the market is caught frantically spinning its legs in vacant space. The federal government responds with more than $1 trillion in new mortgage lending and lending authorizations in multiple guises from Fannie Mae, Freddie Mac, the Federal Housing Finance Board, and the Federal Reserve. Home prices still drop relentlessly; signs of recession proliferate; risky assets plummet.

It has been conventional wisdom that China, Japan, and other countries that run trade surpluses with the US, which means they fund our overconsumption by buying assets like US Treauries, would never restrict the flow of credit to us because it would lower their exports and hurt their growth. We've long been leery of the idea that unsustainable trends will have a life eternal, and Brad Setser has a simple reason why this process is self-limiting. Our foreign funding sources aren't just lending us money to buy their goods; they are also providing the funding for interest on the loans extended for past imports. At a certain point, the interest payments become so large relative to the value of the exports that the deal no longer makes sense.

The day of reckoning may be approaching well before Setser's tipping point. And the trigger is much simpler. We look like a lousy risk. The Freddie/Fannie conservatorship, the Lehman bankrutpcy, and the rescue of fallen Asian powerhouse AIG has, not surprisingly, lead to a reassessment of the US's creditworthiness.

Yu Yongding, who has advised China's central bank, urges Japan, China, and Korea to forge an agreement not to dump US bonds. Yu says in no uncertain terms that the Chinese are worried about their US holdings and see a US default as a real possibility.

We've said before that the US is in the same position as Indonesia and Thailand circa 1996, except we have the reserve currency and nukes. The precariousness of our position is now evident to all, save perhaps the average American citizen.

Japan, China and other holders of U.S. government debt must quickly reach an agreement to prevent panic sales leading to a global financial collapse, said Yu Yongding....

[...]

An agreement is needed so that no nation rushes to sell, ``causing a collapse,'' Yu said. Japan is the biggest owner of U.S. Treasury bills, holding $593 billion, and China is second with $519 billion. Asian countries together hold half of the $2.67 trillion total held by foreign nations....

[...]

China's huge holdings of U.S. debt means it must bear a large proportion of the ``burden of sorting things out'' in the U.S., Yu said. China is not in a hurry to dump its U.S. holdings and communication between the two nations every ``couple of days'' is keeping Chinese leaders informed and helping to avoid a potential panic, he added.

``China is very worried about the safety of its assets,'' he said. ``If you want China to keep calm, you must ensure China that its assets are safe.''

Yu said China is helping the U.S. ``in a very big way'' and added that it should get something in return. The U.S. should avoid labeling it an unfair trader and a currency manipulator and not politicize other issues, he said.

So there you have it: not only might the other shoe drop, but just the threat of it happening gives political leverage to the Asian authorities. Of course, we have no one to blame but ourselves.

Wednesday, September 24, 2008

I recently tried to explain the importance of the financial crisis to a bailout-skeptical friend, who is a medical doctor, with these words:

Let me put it this way: how would you feel if you woke up tomorrow and found you couldn't use your credit or debit card and couldn't access the funds in your bank account in any way? Or consider how long your hospital could function if it could not tap into its lines of credit or access its funds. Just go and ask your hospital CFO. More generally, the real side of the economy--the side where goods and service get produced--would come to a grinding halt if credit stopped flowing. This has become a real concern lately.

I think this is a point that many people miss. Our economy is so incredibly dependent on a smooth functioning financial system that its absence would devastate our day-to-day lives. Yet many people fail to appreciate this dependency and thus find it hard see the importance of stabilizing the financial system. What they see instead is the bailing out of Wall Street Fat Cats.

Now one can question the details of the proposed bailout, but that is a different issue. One can also raise questions about moral hazard, but at this juncture any moral hazard concerns are dwarfed by the threat of financial system meltdown. This intervention is all about maintaining our financial system. Bloomberg's John Berry argues this very point:

In the days since Treasury Secretary Henry Paulson released his $700 billion plan to restore stability to financial markets, the essential point has been lost in all the complaints about bailing out banks and greedy executives.

Why should such institutions be helped when ordinary American taxpayers -- who have managed their own finances prudently and are being battered by a loss of wealth and jobs -- have to pick up the tab?

Because there's no choice.

The fuss about the purpose of the plan and the sense that it was really just intended to help a bunch of fat cats had reached a point that Federal Reserve Chairman Ben S. Bernanke, testifying yesterday before the Senate Banking Committee, stressed that he was a college professor, had never worked on Wall Street and had no connection to it. His only concern, he said, was the future of the economy.

The credit markets are in a ``fragile condition'' and not functioning properly, Bernanke said. If no action is taken, more jobs will be lost, more houses foreclosed and the economy will contract because credit won't be available.

``There will be significant adverse consequences for the average person in the United States,'' Bernanke said.

The [money demand] relationship... holds very well until the mid-1980s but not well at all after that. This could be because the demand for money is not a stable relationship after all... Another conclusion, which is our view, is that the measure of money is not a stable measure. In particular, we argue that technological innovation and changes in regulatory practices in the past two decades have made other monetary aggregates as liquid as M1, so that the measure of money should be adjusted accordingly. We show that once a more appropriate measure of money is taken into consideration, the stability of money demand is recovered.

As noted above, the authors find MZM to be the appropriate measure of money. MZM is defined as M2 minus small denomination time deposits plus institutional money market mutual funds. The main idea behind MZM is that it is an aggregate measure of money that includes all forms of money that can be immediately turned into purchasing power--there are no time restrictions on the money balances. In making the case for MZM the authors go through the list of reasons for the instability of demand for M1 and M2:

...[A] series of sweeping regulatory reforms and technological developments [since the early 1980s]in the banking sector have significantly changed the way banks operate and the way people use banking services and conduct transactions. First, the Depository Institutions Deregulation and Monetary Control Act of 1980 abolished most of the interest rate ceilings that had been imposed on deposit accounts since the Banking Act of 1933 and authorized nationwide negotiable orders of withdrawal accounts (NOWs), which are interest-bearing checking accounts classified in M1. Furthermore, the Garn–St Germain Depository Institutions Act of 1982 authorized money market deposit accounts (MMDAs), interest-bearing savings accounts that can be used for transactions with some restrictions. MMDAs are classified in M2. These two major banking reforms blurred the traditional distinction between the monetary aggregates M1 and M2 in their transactions and savings roles. Second, the rapid development of electronic payments technology and, in particular, the growing use of credit cards and the automated clearinghouse (ACH) as means of payment, reinforced the effect of the banking reforms in slowing down the growth of M1. Both credit cards and ACH transactions can be settled with MMDAs and, therefore, with M2 rather than M1. Third, the widespread adoption of retail sweep programs (discussed in detail later) by depository institutions since 1994, which reclassify checking account deposits as saving deposits overnight, reduced the balances that were classified in M1 by almost half.

These fundamental changes in the regulatory environment and the transactions technology justify the use of a different measure of money after 1980... We show that changing the monetary aggregate measure from M1 to MZM from 1980 onward preserves the long-run relationship between real money, the opportunity cost of money, and economic activity up to a constant factor.

The authors then go on to empirically estimate a stable money demand function with MZM and show that there is no "case of the missing money" with this monetary aggregate. One interesting series of graphs they report plots the ratio of a monetary aggregate to GDP against the nominal interest rate. Some interesting inverse relationships emerge from these figures. I have reproduced the graphs below, but here have flipped the monetary aggregate to GDP ratio. See if you note any striking differences in this relationship based on the monetary aggregate used (click on graphs to enlarge):

I find it striking that GDP/MZM tracks the nominal interest rate series so much more closely than the other monetary aggregates beginning in the late 1970s. Let's say these results hold up going forward. A key implication would be that U.S. monetary policy could once again look at a monetary aggregate.

Update: John Carlson and Benjamin Keehn come to a similar conclusion here.

As bad as it has been in U.S. financial markets, Ken Rogoff reminds us that it could be, and may yet become, worse:

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America’s flagship financial sector, the public and private sector’s massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

In other words, in spite of the financial meltdown going on in the United States foreigners continue to fund the United States living beyond its means as evidenced by the strength of the dollar. (Click on graph to enlarge.)

As Brad Sester notes, though, this foreign financing as of late is (1) coming only from the public sector in foreign countries and (2) even they are running from assets other than safe U.S. treasuries. On this latter point Brad points to a disturbing development reported in the Treasury's TIC data:

[The TIC data] tells a simple story: demand for risky US assets disappeared in the month of July. That continues a long-standing trend. But that trend intensified significantly. And I suspect its intensity increased even more in August.

Among other things, the TIC data challenges the common argument that sovereign investors have been a stabilizing presence in the market. Best I can tell, sovereign investors joined private investors in retreating from all risky US assets in July, and thus added to the underlying distress in the market. I don’t fault sovereigns for limiting their risk. It has proved to be a sound financial choice. But I also find it hard to square their (inferred) actions in the market with many claims about their behavior.

The TIC for July pains a very clear picture: Treasuries were the only US asset foreign investors were willing to buy. Foreigners bought $34.3b of long-term Treasuries, while selling $57.7b of Agencies, $4.2b of corporate bonds and $5.2b of equities. On net, foreigners sold about $25b of long-term US assets.

So even though foreign monetary authorities continue to support the dollar through purchases of U.S. securities they are doing so in a increasingly selective manner. As bad as the markets are now, it could get dramatically worse should this source of foreign financing dry up. It does not take a very imaginative mind to wonder how long before this other shoe drops too.

Last week we argued that, with the nationalization of Fannie and Freddie, comrades Bush, Paulson and Bernanke had started transforming the USA into the USSRA (United Socialist State Republic of America). This transformation of the USA into a country where there is socialism for the rich, the well connected and Wall Street (i.e. where profits are privatized and losses are socialized) continues today with the nationalization of AIG.

[...]

So, with the nationalization today of AIG, comrades Bush, Paulson and Bernanke welcome you again to the USSRA. At least in the case of Fannie and Freddie these two institutions were semi-public to begin with as they were Government Sponsored Enterprises (GSEs). Now we get instead the first pure case of a fully private company, actually the largest insurance company in the world, being nationalized. So the US government is now the largest insurance company in the world. So the transformation of the USA into the USSRA goes a step further.

Not to be outdone on the clever commentary, Tyler Cowen points us to the Federal Reserve's new commercials it inherited with its effective acquisition of AIG:

Friday, September 5, 2008

There has been a lot of discussion recently on the stance of monetary policy. As noted over at Macroblog, many observers believe that monetary policy has been too loose as evidenced by the negative real (or inflation-expectations adjusted) federal funds rate. These observers are concerned that a negative real policy rate may cause, all else equal, inflationary expectations to become unanchored and lead to a repeat of the 1970s-like inflationary spiral. Some observers argue, though, that all else is not equal and that negative real interest rates do not necessarily imply these outcomes. Rather, one must look at real fed funds rate relative to its neutral rate value. Paul McCulley of PIMCO puts it this way:

All sensible discussion of the “right” real Fed funds rate logically must begin with the proposition that the putative “neutral” equilibrium real Fed funds rate is not constant, but rather time varying, a function of financial conditions, notably whether levered financial intermediaries – conventional banks, as well as shadow banks, a term I coined last year at Jackson Hole – are ramping up or ramping down their leverage. The former will lift the “neutral” real rate while the latter will reduce it. Thus, a high Fed funds rate may not be restrictive at all while a low Fed funds rate might not be stimulative at all.

I too agree one should look at the neutral rate value when assessing what the fed funds rate tells us about the stance of monetary policy. However, I would go beyond just financial conditions as suggested by McCulley and also consider productivity growth, intertemporal preferences, and population growth--the determinants of the natural interest rate in a standard growth model-- in assessing the neutral interest rate. Doing so, however, is non-trivial task and many sophisticatedeconometric attempts have been made with mixed results to estimate the neutral rate.

One easy way to get a sense of whether the fed funds rate is near its neutral rate is to use what I call the policy rate gap measure: the difference between the year-on-year nominal growth rate of the economy and the federal funds rate. This measure, popular with TheEconomist magazine and some industry economists, shows monetary policy to be too loose when the federal funds rate is significantly below the economy's nominal growth rate and too tight when it is significantly above it. According to Brian Wesbury, the federal funds rate should be within 1% of the economy's nominal growth rate to be neutral. This measure is convenient because it provides an approximation to a neutral fed funds rate without having to resort to real values. [Both measures are in nominal terms so the inflation component drops out in the differencing.]

I have been highly interested in this measure and have shown previously that it does a good job predicting recessions. One issue that has recently come to my attention, though, is how to best measure the economy's nominal growth rate. Previously, I used nominal GDP in constructing this measure. However, some commentators have pointed to Gross Domestic Income as a better measure of current economic activity. Jeremy Nalewaik, in particular, has shown that “real-time GDI has done a substantially better job recognizing the start of the last several recessions than has real-time GDP.” With these findings in mind I constructed the policy rate gap measure with both GDP and GDI to get a sense of the stance of monetary policy today. Here is what I got (click on to enlarge):

These figure indicates that if GDI is used, monetary policy is indeed neutral as suggested by Paul McCulley. If, however, GDP is used then there is a stronger case that monetary policy has been loose. Currently I am inclined to cast my lot with GDI--the bad economic news today seems to confirm my prior--and conclude monetary policy is more or less neutral. For good measure, I also made note in the graph of the massive Greenspan monetary easing of 2003-2005.

Update: Although it may be clear to some readers, the above post does not explain why the policy rate gap can be considered a measure of the stance of monetary policy. To correct this omission, I turn to The Economist magazine who says the the way to “interpret this [measure] is to see America’s nominal GDP growth as a proxy for the average return on American Inc. If the return is higher than the cost of borrowing[i.e. the interest rate], investment and growth will expand [and vice versa]. Alternatively, one could argue if the real economy is growing faster as the result of productivity gains or population growth (via increased labor supply, which in turn implies a higher marginal product of capital, ceterisparibus) and assuming intertemporal preferences are relatively stable, then the real interest rate should be higher too. Throw in the nominal component to the measures of the real economy and real interest rate and one should see similar movements and/or convergence in the nominal growth rate of the economy and the federal funds rate. If these patterns are absent, then one can argue that monetary policy is causing the real rate to deviate from the rate implied by the fundamentals.

Monday, September 1, 2008

Josh Hendrickson directs us to Bloomberg's On the Economy podcasts with Tom Keane. Josh directs us specifically to the August 21 podcast on the credit crunch where several influential observers are interviewed by Tom Keane. The other podcasts also look interesting. They seem to cover the hot economic and market topics of the day.

Be sure to also check out Russ Robert's podcasts at EconTalk. He does a great job interviewing experts and book authors on a number topics from an economic perspective.

Then try the movie I.O.U.S.A. It is an action-packed, suspense-filled Summer film about... (drum rolls please) our national debt! Okay, so it may not sound that exciting to you, but maybe The Economist magazine can convince you to give it a try:

Promisingly, the new film was well received at the Sundance Film Festival. Some even wonder if it might do for the economy what Al Gore’s “An Inconvenient Truth” did for the environment—perhaps with this comparison in mind, Mr Walker and his supporters talk of a “red-ink tsunami” and bulging “fiscal levees”. But, unlike the former vice-president, he is no heavy-hitter. And, even jazzed up with fancy graphics, punchy one-liners and a splash of humour, courtesy of Steve Martin, tales of fiscal folly are an acquired taste. Still, “I.O.U.S.A” is a bold attempt to highlight a potentially huge problem. “The Dark Knight” it may not be, but for those who care about economic reality as much as cinematic fantasy, it might just be the scariest release of the summer.

Charles Calomiris gave a paper at the Jackson Hole meetings on the current housing boom-bust cycle. Calomiris argues in the paper that the simultaneous occurrence of two "longstanding incentive problems" and two "unusual historical circumstances" gave rise to the perfect financial storm we now know so well.

From the paper:

The longstanding problems were (1) asset management agency problems of institutional investors and (2) government distortions in real estate finance that encouraged borrowers to accept high leverage when it was offered. But these problems by themselves do not explain the timing or severity of the subprime debacle. The specific historical circumstances of (1) loose monetary policy, which generated a global savings glut, and (2) the historical accident of a very low loss rate during the early history of subprime mortgage foreclosures in 2001-2002 were crucial in triggering extreme excessive risk taking by institutional investors. The savings glut provided an influx of investable funds, and the historically low loss rate gave incentive-conflicted asset managers, rating agencies, and securitisation sponsors a basis of “plausible deniability” on which to base unreasonably low projections of default risk.

I find myself in agreement with Calormiris' take on the origins. I especially like his argument that loose monetary policy created the global saving glut, not the other way around as argued by many observers. Calomiris also discusses the Fed's response to the crisis. He argues the Fed's "surgical" strikes (e.g. Bear Sterns) prevented a meltdown of the financial system, but its low fed funds rate policy has been eroding the Fed's inflation-fighting credibility. He also discusses some reforms going forward. Finally, the paper has a lot of interesting financial history in it. Collectively, these various parts make the paper a good supplement to a money and banking class. I plan to use it this fall in my classes.